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February 2014 Vol. No. 1 Investment Updates

Advisor Corner

Please enjoy our Februarynewsletter. We invite yourfeedback. Let us know whattopics you would like to readabout.

Chasing Performance

Investors often endure poor timing and planning asmany chase past performance. They buy into fundsthat are performing well and initiate a selling spreefollowing a decline. This becomes evident whenevaluating a fund’s total return compared with theinvestor return. Overall, the investor return translatesto the average investor’s experience as measured by thetiming decisions of all investors in the fund.

The image illustrates the investor return relative to thetotal return for a given fund. Over the short term, boththe total and investor returns were positive andrelatively similar. Over a 10-year period, however,total return greatly exceeded investor return. Investorswho attempted to time the market ran the risk ofmissing periods of exceptional returns.

Dieter Drews, J.D.Founder/CEO

[email protected]

Prism Capital Management, LLC Investment Updates February 2014 2

Fund Flows and Asset ClassPerformance

Over the last 20 years, markets have experienced manyshocks and recessions, including the Asian currencycrisis, the Russian debt default, the dot-com crash ofthe early 2000s, and the recent global financial crisis.When these events occur, investors frequently attemptto reduce (or increase) investments to certain assetclasses in order to lower exposure to (or take advantageof) the situation.

In 2008, the global financial crisis caused U.S. largestocks and international stocks to perform poorly, withlosses of 37.0% and 43.1%, respectively, while bondsrose by 25.9%. In the wake of the recession, bondsperformed very well in 2011, returning 28.2% asconcerns about a possible double-dip recession grew.In the same year, international stocks fell 11.7%, mostlikely the result of events such as the sovereign debtcrisis that rippled throughout the global landscape.

For all asset classes, demand and supply determine themarket price of an investment. Understanding thistrend may help investors ascertain how an asset classfits into their portfolio. Starting in 2007, annual netasset fund flows into U.S. stock funds became negativeand stayed that way through 2012. Flows into bondfunds, on the contrary, reached a peak in 2009 andremained high in 2010, 2011, and 2012 as investorsflocked to relatively safer assets. As bond returns grewunusually high over the last few years, flows into bondfunds may have increased as investors chased bondperformance. Interestingly, outflows from U.S. stockfunds continued despite U.S. large stocks showingpositive returns since 2009. Was chasing bondperformance the right thing for investors to do, or didinvestors just miss out on the returns of U.S. largestocks over the last couple of years?

About the data

U.S. Large Stocks—S&P 500® Index, which is anunmanaged group of securities and considered to berepresentative of the U.S. stock market in general.International Stocks—Morgan Stanley CapitalInternational (MSCI) World ex-U.S. Index.Bonds—20-year U.S. government bond. Annual NetAsset Fund Flows: U.S.-domiciled open-end fundflows from Morningstar. Start date of 1994

constrained by data availability. U.S. stock: funds thatprimarily invest in U.S. stocks; International stock:funds that invest in specific regions or a diversified mixof international stocks with 40% or more in foreignstocks; Bond: taxable bond funds (government,corporate, international, emerging markets, high yield,multisector) that invest primarily in fixed-incomesecurities of varying maturities.


ETFs Versus Actively Managed Funds

Do we have a winner? Ever since passively-managedfunds like exchange-traded funds (ETFs) came intobeing, there has been much debate about activemanagement versus passive management. Researchpublished by industry professionals presents differentarguments. Some studies show that only a fraction ofactive funds beat their respective benchmarks. Otherstudies show that, while active funds have failed tobeat their benchmarks, they do provide added-valuewhen a disciplined approach is adopted over longerperiods.

An exchange-traded fund strives to achieve a returnsimilar to a particular market index. The ETF willinvest in either all or a representative sample of thesecurities included in the index that it is seeking toimitate. ETFs provide passive diversification, are tax-efficient investment vehicles and have cost advantages.However, the return on an ETF is capped by thereturn of the index it tracks. Active managers, on theother hand, attempt to pick the best investments inthe market and, if well executed, their performance isnot limited by the return on an index. However, activefunds are prone to style drift—the tendency of a fundto deviate from a particular investment style over timeto improve performance. These modifications ininvestment style may be attributed to changing trendsin the market environment.

Let’s take a look at how the “average” ETF and“average” active fund performed over the last decade.The image compares the performance of the “average”ETF with the “average” actively managed mutual fundduring the past 10 years. As evident from the image,in periods of poor market performance (2008 and2011) when the market experienced negative or verylow returns, the “average” actively managed mutualfund performed better than its passive counterpart.When the market experienced strong positiveperformance, ETFs fared better in some years (2004 to2007, for example). In other years, actively-managedfunds performed better (2012 and 2013).

Why is this, you may ask? One reason for thisbehavior is the underlying structure of active andpassive funds. Passive funds like ETFs are designed totrack a particular index or benchmark. This means that

when the benchmark experiences poor performance,the ETF also fares badly. On the other hand, activemanagers may be able to quickly adjust their portfoliosdepending on the underlying market conditions. Thismay be one reason for better performance in downmarkets.

Making a choice between active and passive investingisn’t an easy one. When deciding which style ofmanagement is better for you, it is important to takeinto account several factors, such as costs, style, risk,transparency of investments, manager performance,and tax implications. Consult your financial advisor tolearn more about investing in ETFs and activelymanaged funds.


Short-Term Focus: Coping with Near-Term Fluctuations

Instant access to real-time quotes and media reportscan make it difficult for investors with a long-terminvestment horizon to stay focused on their goals. Inreality, these daily market movements may not be asextreme as they seem. As investors look longer term,their perception often changes. Short-term marketfluctuations can be quite volatile, and the probabilityof realizing a loss within any given day is high.However, the likelihood of realizing a loss hashistorically decreased over longer holding periods. Theimage illustrates that while the probability of losingmoney on a daily basis over the past 20 years was 46%,the probability dropped dramatically when analyzingan annual time period—20%. Periodic review of aninvestment portfolio is necessary, but investorsshouldn’t let short-term swings affect their view of thefuture.

©2013 Morningstar, Inc. All Rights Reserved. The information contained herein (1) is intended solely for informational purposes; (2) is proprietary to Morningstar and/or the content providers; (3) is notwarranted to be accurate, complete, or timely; and (4) does not constitute investment advice of any kind. Neither Morningstar nor the content providers are responsible for any damages or losses arisingfrom any use of this information. Past performance is no guarantee of future results. "Morningstar" and the Morningstar logo are registered trademarks of Morningstar, Inc. Morningstar MarketCommentary originally published by Robert Johnson, CFA, Director of Economic Analysis with Morningstar and has been modified for Morningstar Newsletter Builder.

Dieter Drews, J.D.Founder/CEO

Prism Capital Management, LLC601 Union StreetSuite 4200Seattle, Washington 98101

[email protected]

Tel:206-443-4321Fax:866-294-5926

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Economy & Finance